Archive for July 2007

Again, the title is not a fact, but a premonition. Since my last premonition (sadly) came true, maybe there is something to this voodoo analysis after all.

One aspect of the subprime CDO and subsequent contagion that hasn’t gotten much attention (yet) is the influence and impact of risk management systems. In one of my first articles on the blog, I wrote about CDOs and risk management. If you’re anything like me, you’re sick of bloggers saying things like “As I said way back when…” implying that they saw everything coming long before everyone else, so I’ll try to tread lightly.

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The interesting discussion continues over on Nuclear Phynance. Here is my latest:

Hi Cheng,

My opinion on CDS has nothing to do with what is going on in subprime. In my opinion, subprime is just the first “zit” appearing on the face of a pubescent teen’s face who has been eating nothing but junk food for the past 10 years and is about to have a massive breakout.

I’ve heard economists blabber about how strong corporate balance sheets are as they have decreased leverage since 2000-2001, but these same economists have absolutely no clue about CDOs and other avenues for off balance sheet implied leverage. In my opinion, the only thing holding default rates down was the availability of easy credit, not some increased sense of corporate responsibility. I think we will find that most corporations are more highly leveraged than balance sheets would suggest. Now that spreads are widening with a return of risk premium (plus some for good measure), the availability of easy credit, especially in high yield, is quickly disappearing.

A logical next step following reduced easy credit is going to be increased default rates. This I think is going to severely test the CDS market (again nothing to do with subprime), especially when a default occurs on a company whose outstanding CDS protection exceeds the outstanding cash debt by factors of 10 or more. Even if the CDS is not settled physically, the cash needs to come from somewhere. Where will that be? What happens when the person you bought protection from defaults?

Regarding treasuries, close to 50% of all outstanding US government debt is held outside the US.

David Walker, the US comptroller general, indicated that the huge holdings of American government debt by countries such as China, Saudi Arabia and Libya could leave a powerful financial weapon in the hands of countries that may be hostile to US corporate and diplomatic interests.

Mr Walker told The Times that foreign investors have more control over the US economy than Americans, leaving the country in a state that was “financially imprudent”.

He said: “More and more of our debt is held by foreign countries – some of which are our allies and some are not.”

Mr Walker, who heads the Government agency that is responsible for auditing the national accounts and is also the arm of Congress that scrutinis-es spending by the Administration, said that the US has been forced to rely on foreign investors more because Americans are saving so little.

Don’t get me wrong though, I’m not all gloom and doom. There are certainly investment opportunities galore even if what I am preaching does occur. For example, oil is going no where but up. Food prices are going no where but up. Gold is going nowhere but up. Call me crazy, but I think land, i.e. physical land, not necessarily structured paper, is going to go up.Wild times

This morning, we are talking a bit about high yield spreads, CLOs, LBOs, and private equity. Here is my latest contribution

See? It is much more fun to have opinions on the future rather than the past. We will ultimately be able to see who is right rather than looking in the rear view mirror and say what idiots others have been.

Private equity is awash with cash, no doubt, so what are they going to do with it? My opinion is that it is not the intention of private equity to make current shareholders rich (duh!). They’ll only execute an LBO if they think there is profit to be made. Generally, you might think lower equity values would make a company an attractive LBO candidate, but what if the low equity value is because the company’s actual value is decreasing due to deteriorating economic and market conditions? PE will not be catching falling daggers. That coupled with increased financing costs will give PE limited options for investing the cash they are sitting on. If they don’t invest, pension funds and endowments that have gorged them with cash will begin extracting that cash to invest elsewhere. Why pay PE fees for treasury-like (or worse) returns?

The IPO rip cord worked for the partners at Blackstone, but the subsequent tanking will make other PE’s going public more difficult.

High yield spreads measure the difference between the yield on high yield corporate bonds (junk bonds) and US Treasuries. Traditionally, the size of the spread has been inversely correlated to the level of risk aversion among investors. When spreads are low, investors are paying little attention to risk, while high spreads indicate investors are more sensitive to risk.

As we noted last week, spreads in the junk bond market have been widening since the start of June. On June 1st, the spread bottomed at 241 basis points. Since then however, the spread has widened by over 100 basis points to 344, which represents an increase of 43%. Below we highlight the Merrill Lynch High Yield Corporate Bond Spread since 1997 and highlight other spikes in the index.

From all appearances, the birds are starving to death. But no one can say exactly why. “Some feel it’s a natural phenomenon,” Watson says, but he has doubts. “I think the thing that has caused some of us to question this is that it appears to be occurring more frequently.”

[snip]

They may have lacked food when they were being raised as chicks, he says, or just after they left the nest. He speculates that the timing of food availability could have been off, or that the young birds may have missed the feeding locations, en route.

Whenever I hear stories like this, e.g. bees not finding their way back to the hive, birds not finding feeding grounds along the migration path, my thoughts always come back to navigation and the impact that electromagnetic radiation can have on it.

It is undeniable that both bees and many birds use magnetic fields for navigational purposes. It is also undeniable that wireless internet devices, e.g. Wi-Fi routers, data intensive cell phones, iPhone, etc., have greatly increased in popularity. Not only is the proliferation of wireless devices of concern, but it my opinion, the frequencies of that radiation is different than it has been historically. There is a lot more electromagnetic noise in the frequency range greater than 1 GHz these days. For example, Wi-Fi, WiBRO, and WiMAX operate at 2.5 GHz (the same as your microwave oven).

This morning, there is a discussion of disparities between cash and synthetic (CDS) bond markets. Here is my take on the subject:

Investors in cash versus traders in cash/CDS are in many cases from two different planets and in some cases do not even speak the same language. My expectation is that cash will soon follow CDS, but for a time, cash will be artificially inflated as real money investors with significant “dry powder” who do not necessarily understand CDOs are mistakenly seeing bargains when HY widens 30 bps. Once that powder is gone, cash will soon tank as well.